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How China Manages its Currency: An Explanation for Humans

After the big news on the yuan this weekend, everyone fancies themselves an expert on the intricacies of foreign exchange in the Middle Kingdom. Everyone, except MarketBeat, that is.

Like most folks, we understand that China keeps its currency weak by buying up dollars. But as to exactly how this transaction occurs, we confess to having some questions.

Luckily for us, our position here at The Journal allows us to call up folks who actually do understand this stuff, and then pester them incessantly until they explain it to us in small, monosyllabic grunts, we’re capable of digesting.

Ok, say we’re a U.S. manufacturer and want to build a factory in China. To build it, we need to have Chinese currency, because — oddly enough — that’s what people use in China. In order to do that, we’ve got to buy Chinese yuan.

So, we would go to a Chinese bank and change the currency, buying yuan and selling dollars. Now, if the yuan was a free-floating currency, the effect of this exchange — all things being equal — would be to drive up the value of the yuan.

And with all the excitement about the prospects for Chinese growth, a lot of companies likely want to build a lot of factories there. And the cumulative impact of all those inflows of dollars would be to drive the value of the yuan higher — if it was a free-floating currency.

Thing is, it’s not a free-floating currency. It’s pegged. Here’s how it works.

China — being China — has strict rules about what kinds of capital banks can hold,. The bottom line is that, by Chinese law, the bank where we changed our greenbacks into yuan, must then turn those greenbacks over to the central bank, to the government basically. The government then pays the banks for them using yuan. Where does it get the yuan it uses to pay the banks for the U.S. dollars? It prints them. (Just like the Fed — remember quantitative easing? — the People’s Bank of China can print currency.) “It just prints whatever the amount of local currency to buy up any amount of dollar inflow,” Bergsten said.

The rate of yuan per dollar is announced every morning at 9:15 a.m. Shanghai time. That’s 1 a.m. GMT. And 9:15 p.m. the prior day in New York. So that’s what to watch to see where the rubber meets the road as far as implementation of the revaluation is concerned.

On Monday the exchange rate set by the PBOC was the same as on Friday, 6.8275 to the dollar. At least, that’s the central rate. For technical reasons PBOC allows trading to fluctuate in a tight band around that price. The government announces the acceptable trading band daily as well. They currently tolerate 0.5% band around the fixed rate. And on Monday, the yuan is up about 0.5% against the greenback.

Some traders are interpreting that to mean that the Chinese government is going to be a bit more tolerant of a more substantial strengthening yuan than the fixing rate would indicate. The next thing to watch to find out how much the yuan is going to strengthen in the short term, will be Tuesday’s announcement on the price and trading band. That’s due at 9:15 p.m. New York time tonight.